An investment property is real estate bought for the purpose of generating income. Yet, what at first seems like an easy money maker inevitably comes with challenges and costs. First off, buying an investment property involves more stringent financing requirements compared with mortgages on primary homes. Then, once you own the property, you’ll be responsible for ongoing homeownership expenses that can cut into your profits.
What is an investment property?
Buying an investment property allows you to generate income through the renting or resale of a property that isn't your primary residence.
Investment properties can be residential, such as single-family homes, townhouses or condominiums, or commercial properties, which are zoned for businesses such as hotels, restaurants and retail shops.
Investors in residential properties try to make money by collecting rent from tenants or by renovating the property and quickly reselling it for a profit, known as house flipping. The property can also be held long enough to increase in value over time, then sold.
Getting an investment property mortgage
There are differences between obtaining a mortgage for an investment property and for a primary residence.
Here are some of the major ones that lenders consider.
Down payment minimum
The down payment you need depends on how many units the property has and whether you plan to live there:
One-unit property: Typically requires at least 15% down with a conventional loan.
Two-to-four unit property where you do live in one of the units: You may be able to put as little as 5% down.
Two-to-four unit property where you do not live there: Typically 25% down.
Credit score
Getting approved for financing could also be a challenge if your credit needs work.
For a conventional investment property loan, 620 is generally the minimum credit score, but qualifying with a 620 may be more difficult. Lenders might prefer a higher score, sometimes up to 720.
Your credit score will also affect your interest rate and loan terms. Investment property loans are riskier for lenders because borrowers facing financial trouble are more likely to default on an investment property than on their primary home. That’s why the stronger your credit score is, the better your rate and terms may be, which can significantly reduce your monthly payment and improve your overall return on the property.
Extra cash requirements
While it depends on the lender, you may be required to have extensive cash reserves when buying an investment property.
Expect your lender to require that you have at least six months of cash reserves or savings available after closing on your property to ensure you can cover operational and unexpected costs.
Government-backed loan restrictions
In most cases, government-backed loan programs offered by the Federal Housing Administration or the Department of Veterans Affairs aren't an option because those loans are intended for a primary residence only.
However, you may be eligible for these loans if you purchase a multifamily property, as long as you occupy one of the units as your primary residence for at least one year. You could then rent out the remaining units. Here are a couple options:
FHA loan: Purchase a property with up to four units, live in one unit and put down as little as 3.5% if your credit score is 580 or higher.
VA loan: If you’re an eligible veteran, you may be able to purchase a multifamily property with little to no down payment.
» MORE: See NerdWallet's list of the best mortgage lenders for second homes
Factors to weigh before buying an investment property
Before giving into the siren song of investment property income, know that you’ll likely need to shell out a sizable chunk of cash before you start seeing any profit. Also be prepared for potential headaches.
Choosing an area with a steady stream of renters is critical when buying an investment property. Owners also need to be aware of rental laws that vary by state, as well as the potential for having to deal with delinquent tenants.
Here are other aspects of owning an investment property to be aware of:
Maintenance: Maintenance is a significant cost to consider when buying an investment property. You can either hire someone to take care of the property, or you can handle things like rent collection, repairs and snow removal yourself. In general, you should expect to spend between 1% and 4% of the property’s value each year on maintenance, but that will vary depending on factors like how many units it has, when it was built and the condition of major systems like plumbing and electrical.
Property taxes and insurance: Like any property owner, you’ll need to pay taxes and homeowners insurance for as long as you own the investment property.
Utilities: With utilities, you can either include some or all of them as part of the rent, charge them to the tenant each month or require the tenant to set up the utilities in their name and pay the providers directly.
Pros and cons of buying an investment property
Challenges aside, buying an investment property can be a lucrative move. Here’s how the pros and cons stack up:
PROS
The value of your property may rise enough for you to sell and make a profit.
You can benefit from tax deductions on your rental property, such as mortgage interest, property taxes and expenses like advertising, repairs and insurance.
You can gain consistent income from long-term rentals.
You can pay down your mortgage with rental income and build equity in the property.
CONS
You could lose money trying to flip or rent the property.
Mortgage requirements may include higher down payments and interest rates than you would see for a primary residence.
Real estate isn't a liquid asset. If you needed cash, selling the property could be time-consuming and complicated.
You have to hire a property manager or manage the property yourself.
» MORE: How to buy a foreclosed home
What makes a good investment property?
Determining what makes a good investment property depends on some rules of thumb, but also individual goals.
For instance, consistent monthly profit and cash flow is likely a top priority for many who buy an investment property.
When evaluating the profit potential of an investment property, you should consider a number of factors, starting with how much the property could reasonably rent for. One formula, called the 2% rule, indicates that the total monthly rent should equal at least 2% of the total purchase price plus needed repairs.
Look for four factors
Before buying an investment property, look for a combination of four key elements:
Affordability
Appreciation
Local job growth
Population growth
Property values are more likely to increase over time in areas with a solid and expanding infrastructure. Score a few investment properties in a growing market and you have a healthy cash flow from renting them out, you may be able to fund your retirement.
That said, even in a hot market, not all properties are created equal. One house could be in great shape, while the house next store could have problems, such as lack of a view, or worse, previous flood damage. So make sure to inspect every investment property from top to bottom to ensure you don’t get hit with hidden expenses.
